Keep your eye on the prize

17-04-2018 | Column

What a difference three months make! At the end of last year, with an improving global economy underpinning positive earnings revisions, equity markets looked poised for more upside. Something ended up rattling the goldilocks scenario, though.

Fabiana

Fedeli

Portfolio Manager

Speed read

In developed markets, risks are increasing

The forecast for emerging markets is sunny, with clouds

We do not expect a full-blown trade war, but are monitoring the risks

Three months ago, we already pointed out that “nothing ever moves in a straight line”. Call it sixth sense, call it being in the markets for more years than we care to count, this time it was President Trump deciding to wage a trade war that threw a spanner in the works. Or at least he is making concrete threats to do so, possibly with the goal to strike a ‘good deal’ for America.

As economists, we can wonder how good that deal will be for the US consumer or the many US corporates that rely on imported goods. We can see domestic inflationary pressures coming, should the protectionist measures escalate. As investors, we have to decide how to allocate assets in these markets. Our advice is to keep your eye on the prize. Rather than looking at short-term volatility, we should stay focused on the underlying macro dynamics.

The global economic cycle is still improving, and central banks, including the Fed, are moving in cautious and well flagged steps. If this continues, which is the base case of our fundamental equities investment teams, we should use the dips as a buy opportunity. Yet, we need to continue to monitor the risks. Until now, President Trump’s trade tariffs have made more noise than actual economic impact.

Trade war or negotiating tactic?

Given the number of exemptions already granted — Canada and Mexico on a long-term basis, plus Australia, Argentina, the EU, and South Korea at least temporarily — it looks like these tariffs were more of a negotiating tactic than they initially seemed, and that China is the key target. The measures per se have a limited impact on Chinese GDP, which the Chinese government could offset by implementing some form of stimulus. President Trump is also proposing measures to limit China’s investments in ‘sensitive technologies’. This de facto was already the status quo given the strict oversight by CFIUS, the US government body that reviews foreign investments in the country.

While the current status of tariffs is limited, the key question to ask is how big the risk of escalation is, with maybe more US measures, and significant retaliation from China. Thus far, the Chinese government is responding in a firm but measured way. It has announced tariffs on USD 50 billion in US products, contingent on when the US will actually implement its tariffs on Chinese products. It also appears that Beijing and Washington are currently in talks, taking advantage of the 60-day period before the Section 301-based tariffs take effect. We would expect some concessions to be made and the situation to diffuse, not without the occasional tweet.

Double whammy is not our base case

That said, we have to be mindful of the risks, and should all negotiations fail, and a full-fledged trading war break out, equity markets would face the proverbial double whammy. On the one end, earnings might be hit as both exporters and importers, depending on what side of the trade tariffs they sit, suffer. On the other end, we could expect inflationary pressures to ramp up in the US, prompting the Fed to hike rates not in line with the improvement in economic growth (as it has done thus far) but to stem inflation.

A gradual tightening cycle that responds to improvements in the global economy has historically been positive for equity markets, but a steeper tightening path to stem inflationary pressures is likely to have a negative impact. As we said, the latter is not our base case. President Trump likes to rattle his adversaries to make a deal, and China is coming to the table.

While the world is focused on potential trade wars, we see some other elements that need monitoring. Although we are still positive on developed equity markets, we are concerned about volatility over the coming quarter, upcoming protectionism and the risk of further inflationary pressures if the US economy overheats. We are more upbeat about emerging equity markets. Although, here too, trade protectionism and potential inflationary pressure weigh on our optimism, the global economic environment is still supportive for emerging markets, with solid growth across developed and emerging countries and inflation still at a low level.